Chapter 13 – Analyzing and Interpreting Financial Statements
13-7
Chapter Outline
Notes
3. Ratios in this block:
a. Profit margin—net income divided by net sales; describes
the ability to earn net income from sales.
b. Return on total assets—net income divided by average total
assets; a summary measure of operating efficiency;
comprises profit margin (net income divided by net sales)
and total asset turnover (net sales divided by average total
assets).
c. Return on common stockholders’ equity—net income less
preferred dividends divided by average common
stockholders’ equity; measures the success of a company in
earning net income for its owners.
D. Market Prospects
1. Market measures are useful for analyzing corporations with
publicly traded stock.
2. Market measures use stock price in their computation.
3. Ratios in this block:
a. Price-earnings ratio—market price per common stock
divided by earnings per share; used to evaluate the
profitability of alternative common stock investments.
b. Dividend yield—annual cash dividends paid per share of
stock divided by market price per share; used to compare the
dividend-paying performance of different investment
alternatives.
E. Summary of Ratios
Exhibit 13.16 sets forth the names of each of the common ratios by
category, and includes the formula and a description of what is
measured by each ratio.
V. Global View
A. Horizontal and Vertical Analysis – horizontal and vertical analysis
helps eliminate many differences between GAAP and IFRS when
analyzing and interpreting financial statements.
B. Ratio Analysis – ratio analysis has many of the advantages and
disadvantages of horizontal and vertical analysis. The ratios applied
are fine, with some possible changes in interpretation depending on
what and what is not included in certain accounting measures across
GAAP and IFRS.
VI. Decision Analysis—Analysis Reporting
Goal of financial statement analysis report is to reduce uncertainty
through rigorous and sound evaluation. A good analysis report usually
consists of six sections:
Chapter 13 – Analyzing and Interpreting Financial Statements
13-8
Chapter Outline
Notes
1. Executive summary.
2. Analysis overview.
3. Evidential matter.
4. Assumptions.
5. Key factors.
6. Inferences
VII. Sustainable Income – Appendix 13A
When a company’s activities involve income-related events that are not
part of its normal, continuing operations, it often separates the income
statement into different sections as follows:
A. Continuing Operations
Reports the revenues, expenses, and income generated by the
company’s continuing operations.
B. Discontinued Segments
1. A business segment is a part of a company’s operations that
serves a particular line of business or class of customers.
2. A company’s gain or loss from selling or closing down a
segment is separately reported as follows:
a. Income from operating the discontinued segment for the
current period prior to its disposal.
b. The gain or loss from disposing of the segment’s net assets.
C. Extraordinary Items
1. Extraordinary gains and losses are those that are both unusual
and infrequent.
a. An unusual gain or loss is abnormal or otherwise unrelated
to the company’s regular activities and environment.
b. An infrequent gain or loss is not expected to recur given
the company’s operating environment.
2. Reporting extraordinary items in a separate category helps users
predict future performance, absent the effects of the
extraordinary items.
3. Items that are either unusual or infrequent, but not both, are
reported in the income statement but after the normal revenues
and expenses.
D. Earnings per Share (EPS)— is the amount of income earned by
each share of outstanding common stock and is reported in the final
section of income statement. One of the most widely cited items of
accounting information.
E. Changes in Accounting Principles
1. The consistency principle requires a company apply the same
accounting principles across periods (examples in this context:
(include inventory or depreciation methods). Changes in
accounting principles are acceptable if justified as
Chapter 13 – Analyzing and Interpreting Financial Statements
13-9
Chapter Outline
Notes
improvements in financial reporting.
2. Cumulative effect of the change on prior periods’ incomes
should be reported on the income statement (net of taxes) below
extraordinary items.
3. A footnote should describe and justify the change and report
what income would have been under the old method.
.
Chapter 13 – Analyzing and Interpreting Financial Statements
13-10
Chapter 13 – Alternate Demonstration Problem #1
Following are data from the statements of two companies selling similar
products:
Current Year-End Balance Sheets
Sled
Company
Zip
Company
Cash ………………………………………………………………
$ 11,900
$ 20,000
Notes receivable …………………………………………….
7,700
3,200
Accounts receivable, net ………………………………..
42,000
64,000
Inventory ……………………………………………………….
58,800
87,680
Prepaid expenses …………………………………………..
1,680
3,520
Plant and equipment, net ………………………………..
232,120
274,400
Total assets ……………………………………………………
$354,200
$452,800
Current liabilities ……………………………………………
$ 56,000
$ 80,000
Mortgage payable …………………………………………..
70,000
80,000
Common stock, $10 par value …………………………
140,000
160,000
Retained earnings ………………………………………….
88,200
132,800
Total liabilities and stockholders’ equity …………
$354,200
$452,800
Beginning–of-Year Data
Inventory ……………………………………………………….
$ 53,200
$ 85,120
Total assets ……………………………………………………
345,800
443,200
Stockholders’ equity ………………………………………
217,000
285,120
Data from the Current Year’s Income Statement
Sales ……………………………………………………………..
$672,000
$880,000
Cost of goods sold …………………………………………
528,080
699,840
Interest expense …………………………………………….
4,200
5,600
Net income …………………………………………………….
23,373
28,896
Required:
1. Calculate current ratios, acid-test ratios, inventory turnovers, and
days’ sales uncollected for the two companies. Then state which
company you think is the better short-term credit risk and why.
2. Calculate return on total assets employed and return on
stockholders’ equity. Then, under the assumption that each
company’s stock can be purchased at book value, state which
company’s stock you think is the better investment and why.
Chapter 13 – Analyzing and Interpreting Financial Statements
13-11
Solution: Chapter 13 – Alternate Demonstration Problem #1
Part 1:
Sled Company
Zip Company
$122,080
$ 56,000
= 2.18 to 1
$178,400
$ 80,000
= 2.23 to 1
$ 61,600
$ 56,000
= 1.10 to 1
$ 87,200
$ 80,000
= 1.09 to 1
$528,080
$ 56,000
= 9.4 times
$699,840
$ 86,400
= 8.1 times
$ 42,000
$672,000
x 365 = 22.8
$ 64,000
$880,000
x 365 = 26.5
Sled Company and Zip Company have almost equal current and acid–test
ratios, so near the same that the differences are not significant. However,
Sled Company turns its inventory and collects its accounts receivable
more rapidly than Zip Company; and on this basis it appears to be a
better short-term credit risk.
Part 2:
Return on total assets:
$ 23,373
$350,000
= 6.68%
$ 28,896
$448,000
= 6.45%
Return on stockholders’
equity:
$ 23,373
$222,600
= 10.5%
$ 28,896
$288,960
= 10.0%
Assuming that the stock of each company could be purchased at book
value, Sled Company’s stock seems to be the better investment. This
conclusion is based on Sled’s slightly better return on stockholders’
equity (or return on the investment) of 10.5% compared with 10% for Zip.
In addition, the better inventory turnover, days’ sales uncollected, and
return on total assets employed indicate that Sled Company might be the
better managed company. This information reinforces the conclusion as
to which stock is the better investment.